What is monetary policy? The role of monetary policy in the economy

Monetary policy or monetary policy is one of the policies that have an impact on the development of the economy. Changes in monetary policy can directly or indirectly lead to changes in several factors in the economy.

An overview of monetary policy

What is monetary policy?

Monetary policy is the policy of using the tools of credit and foreign exchange activities to stabilize the currency. Thereby, stabilizing the economy and promoting growth and development.

Simply put, monetary policy is the macroeconomic policy implemented by the central bank (or monetary authority). The central bank implements monetary policy to achieve the government’s macroeconomic goals such as price stability, unemployment rate, economic growth, etc.


Classification of monetary policy

Monetary policy is divided into two types: expansionary monetary policy and tight monetary policy.

Expansive monetary policy

Expansionary monetary policy, also known as loose monetary policy, is a policy in which the Central Bank expands the money supply to a larger than normal level for the economy, causing interest rates to fall, thereby causing increase aggregate demand, will create jobs for workers, promote investment to expand production and business. As a result, the scale of the economy expands, income increases and the unemployment rate decreases.

To carry out an expansionary monetary policy, the Central Bank can usually do one of the following three ways:

  • Buy on the stock market
  • Lower the reserve requirement ratio
  • Lower the discount rate
  • In some cases it is possible to do 2 or 3 ways at the same time.

In the macroeconomy, loose monetary policy is applied in the context of economic recession and rising unemployment rate. Therefore, expansionary monetary policy is synonymous with anti-recession monetary policy.

Tight monetary policy

Tight monetary policy, also known as contractionary monetary policy, is a policy that the Central Bank affects to reduce the money supply in the economy, thereby causing interest rates in the market to increase. Thereby narrowing aggregate demand, causing the general price level to fall.

Usually tight monetary policy is applied when the economy of a country has overdeveloped, inflation is increasing. Therefore, tight monetary policy is synonymous with anti-inflation monetary policy.

To implement this monetary policy, the Central Bank often uses measures to reduce the money supply through the following ways:

  • Sold on the stock market
  • Increase required reserve level
  • Increase discount rates, strictly control credit activities…

Depending on the performance of the economy, the macroeconomic objectives in each development period, the Central Bank may implement either of the above two monetary policies to bring stability to the economy. economy of the country.

See also: What is corporate governance? Contents of corporate governance

What are the factors that affect monetary policy?

Monetary policy in the macro economy will be affected by many related factors. Below are some of the factors that influence monetary policy.

– Competitiveness and diversification of financial markets: Accordingly, if a financial market has little competition, market share is mainly concentrated in a few large banks, the ability of monetary policy to regulate will also be affected. In addition, the development of other markets such as securities, insurance, derivatives markets, etc. also create impacts on the impact of monetary policy. The more factors affecting money supply outside of bank credit, the more limited the impact of monetary policy will be.

– Financial status of individuals, households, and businesses: The financial status of individuals, households or businesses affects monetary policy in three ways:

  • The impact of monetary policy on consumption and investment behavior of individuals and businesses will depend on the extent to which these costs are financed through the financial system (i.e. access to capital).
  • The impact of monetary policy on asset prices such as stocks, real estate, etc. will depend on the structure of financial investment portfolios of individuals and businesses.
  • The initial financial position of individuals and businesses also affects the impact of monetary policy on decisions made. Therefore, in countries where consumption and investment are mainly based on saving or reinvesting from profits, the impact of monetary policy will be more limited than in countries dependent on credit capital. .

– Foreign exchange policy: Under the conditions of liberalization of capital transactions, the effectiveness of monetary policy will be affected by foreign exchange policy and the ability to substitute between domestic and foreign assets. Therefore, when the substitution is stable, all monetary policy actions will be neutralized through the movement of capital flows. Increasing access to capital from abroad will also help businesses become less dependent on domestic credit, thereby reducing the impact of monetary policy on aggregate demand.

– Dollarization in the financial market: In the financial market, dollarization is common and it poses many challenges to the formulation and administration of monetary policy from the general statistics The amount of money, determining the goals.. The dollarization of cash will limit the ability to measure the money supply in the economy. In particular, when there is a dollarization of both assets and liabilities, it will lead to risks due to term imbalance and currency difference.

Tools of monetary policy

To regulate the money supply in the economy, monetary policy will use the following tools:

Required reserve ratio

This is the ratio of the amount of money that needs to be reserved to the total amount of deposits. This is the rate that the Central Bank requires commercial banks to guarantee. When the reserve requirement ratio changes, the money supply changes. If the reserve requirement ratio increases, the money supply will decrease. So by changing the reserve requirement ratio, the central bank can regulate the money supply.

Open market operations

In macroeconomics, open market operations operate when the Central Bank buys or sells financial securities on the open market. This will affect the reserve volume of commercial banks, thereby affecting the credit supply capacity of commercial banks, leading to an increase or decrease in the amount of money.

Example: If the central bank prints an extra 1 million Peso and uses them to buy government bonds on the free market. At this time, commercial and private banks lost a million Peso worth of securities but in return, they gained another million Peso in cash, which increased the money supply. If the central bank sells one million Peso of government bonds, the process will reverse and the money supply will decrease.

Discount rate

This is the interest rate at which the Central Bank lends to commercial banks to meet unusual cash needs. The monetary authority can change the interest rate it lends to banks, thereby adjusting the amount of the base currency. When the money base changes, so does the money supply. When the rediscount rate is high, commercial banks will find that the cash reserve is too small to meet the unusual withdrawal needs of customers, which will cause these banks to pay high interest rates when they have to borrow from the Bank. central government in case of shortage of reserves. That will cause commercial banks to be wary and voluntarily reserve more. And it will also help reduce the money supply in the market.


The role of monetary policy in the economy

In the macroeconomics, monetary policy plays an extremely important role in regulating the volume of money circulating in the entire economy. Accordingly, through monetary policy, the central bank can control the monetary system, thereby curbing and repelling inflation, stabilizing the purchasing power of the currency to promote economic growth. In addition, monetary policy is also a tool to control the entire system of commercial banks and credit institutions. As follows:

Control unemployment rate – Create jobs

Monetary policy, whether expanding or contracting, will also have a direct impact on the effective use of social resources, the scale of production and business, thereby affecting the unemployment rate. Accordingly, in order to have a falling unemployment rate, the economy must accept an increased inflation rate.

This places on the Central Bank the responsibility to use monetary tools to contribute to the enhancement and expansion of investment, production and business, and at the same time to actively participate in the continuous, stable and sustainable growth. the unemployment rate does not exceed the natural increase in unemployment.

Economic growth

For monetary policy, economic growth is the first and most important goal. Economic growth is expressed through two factors: interest rate and general demand. Accordingly, the increase or decrease in the monetary block has a strong impact on the interest rate and the overall demand, thereby affecting the increase in production investment, affecting the total national output, that is, on the the growth of the economy. Therefore, monetary policy must aim at economic growth by increasing or decreasing the appropriate amount of money in the economy.

Stable price in the market

In the macro-economy as well as in the micro-economy, price stability plays an important role in helping the State plan effective economic development orientations because it has eliminated price fluctuations. Stabilizing prices will help create a stable investment environment, thereby contributing to attracting investment capital, promoting businesses and individuals to produce profits for themselves and the society.

Stable interest rates

The stabilization of interest rates is the implementation of credit interest rates to provide means of payment for the national economy through banking credit operations. Accordingly, it is based on lending funds created from deposit sources of the society and with a flexible interest rate system, in line with the movement of the market mechanism.

Stabilizing financial and foreign exchange markets

Monetary and fiscal policy stabilizes the financial markets to govern the economy of each government. Financial market stability is also driven by interest rate stability, which can cause instability in financial institutions.

For the foreign exchange market, the stable exchange rate not only has a positive impact, but it also has great significance for strengthening the confidence of foreign investors because the exchange rate policy is always a factor. Important macro for foreign investors to consider when they intend to invest in a certain country. Exchange rate fluctuations will affect the purchasing power of the currency, thereby affecting the operation of the economy (depending on the degree of outward orientation of the economy).

However, besides the important roles, monetary policy also has certain limitations:

  • The effect of monetary policy will be low when private investment is not sensitive to interest rates. When the interest rate increases, the cost of input (capital) of the enterprise increases, this causes the price of output goods to continue to rise, and inflation is not controlled. Therefore, monetary policy will be less effective.
  • Monetary policy will be ineffective if the government is not committed to controlling the printing of more money. Accordingly, when the government wants to control inflation by using a tight monetary policy, under pressure to cover the budget deficit, the government can print more money. That will have the opposite effect of tight monetary policy.
  • The use of expansionary monetary policy can cause interest rates to fall too low, which makes individuals reluctant to deposit money in banks and decide to hold cash. This will cause the commercial banking system to lack capital to lend and it will affect private investment that cannot be expanded, reducing the effectiveness of the policy.

Answers to questions related to monetary policy

Compare the difference between monetary policy and fiscal policy

Fiscal policy and monetary policy are two important macroeconomic regulatory policies. However, these two policies have many differences, details are presented in the following table:

Comparative criteria Monetary Policy Fiscal policy
Define The process by which a country’s monetary authority controls the money supply to achieve macroeconomic goals such as price stability, unemployment, economic growth, etc. The use of government spending and revenue to influence the economy.
Rule Manipulating money supply to affect economic outcomes such as economic growth, inflation, exchange rate, unemployment rate, etc. Manipulating the level of aggregate demand in the economy to achieve economic goals such as price stability, full employment, and economic growth.
Policy implementation tool           – Interest rate

– Required reserve ratio

– Exchange rate policy

– Open market operations…

         Taxes and government spending
Policy maker Central bank Government

What is monetary policy under the exchange rate regime?

Monetary policy under an exchange rate regime means the effect of exchange rates on the effectiveness of monetary policy in a country. Whereby:

  • The implementation of a floating exchange rate regime would limit the government’s ability to operate an independent domestic monetary policy to maintain domestic economic stability, but in practice, many governments still prefer a fixed exchange rate regime because it creates stability.
  • A fixed exchange rate regime provides stability, but it is relatively difficult and costly to implement policy measures to keep the exchange rate fixed, and above all makes the government monetary policy becomes invalid

What is contractionary monetary policy?

A contractionary monetary policy is a policy implemented by raising various key interest rates controlled by the central bank, or other measures aimed at increasing the supply of money. money.

The purpose of contractionary monetary policy is to reduce inflation by limiting the amount of money in circulation currently in the market. At the same time, this policy also aims to tame the amount of speculative capital and unsustainable investment that the previous expansionary policy created.

What is inflationary monetary policy?

Inflationary monetary policy is essentially contractionary monetary policy. When the economy of a country has overdeveloped, inflation is increasing, this policy will be applied, so tight monetary policy is synonymous with anti-inflationary monetary policy. monetary policy inflation.


Monetary policy is one of the important policies contributing to stabilizing economic growth. Above is detailed information about monetary policy, monetary policy tools, its role in the economy as well as monetary policies that Philippines is applying. We hope you have gained a deeper understanding of this subject through this article.

See also: What is the exchange rate? Classification and role for the economy

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